Blog: COLI 201 - Application of COLI

Corporate owned life insurance (COLI) policies are designed much like individual life insurance policies. Both types of policies are funded by the policy owner and provide coverage for a beneficiary in the event of the death of an insured individual. The key differentiators between COLI and individual life insurance are the purpose of the policies. Individual life insurance is typically intended to replace lost earnings when the primary bread winner dies, or to provide a source of funds to pay estate taxes due at death for wealthy individuals. COLI provides coverage for a business in the event of the death of an insured individual, who is generally a key executive or owner, or as a tax-advantaged investment vehicle to accumulate assets for an executive benefit plan.

COLI 201 is the second installment in a series designed to demystify corporate owned life insurance (COLI). This series aims to define what COLI is, who buys COLI, common reasons why COLI policies are purchased and more.

There are several reasons why a company may want to take out a life insurance policy or policies on key employees. Typically, the reasons are financial – either to provide financial protection from the loss of a key person or as a long-term investment because of its tax-advantaged characteristics.

Protecting a Business
A sole proprietorship or family-owned business may take a COLI policy out on the president of the company to provide a safety net to continue business operations after the individual passes away, to buy out the company stock owned by the deceased individual, or to provide money to settle debts with creditors and avoid complications when closing the business. Depending on the size of a company, it might decide to purchase COLI on more than one person to ensure its financial stability. This level of protection is common and consistent with how an individual might enter into a policy for financial protection of their family. It is not uncommon for a small business owner to have two life insurance policies – one personal policy for their family and one owned by the business for the benefit of the business.

Evolution of COLI as an Investment Strategy
The United States government has historically imposed little to no tax burden on death benefits paid out to beneficiaries of life insurance policies. This is because the life insurance death benefit exists to provide financial support for the beneficiary; taxation on the death benefit payment diminishes the benefit and, if taxation on the death benefit became prevalent, the tax could potentially create instability in the marketplace because fewer policies would be taken out.

Historical Application
Prior to the 1990s, many sophisticated corporate finance teams recognized the tax-efficient characteristics of life insurance and took out individual policies on employees from broad segments of their employee base; many policies were taken out without the knowledge or consent of the employee(s). These corporations acquired permanent life policies and named the business as the beneficiary and the employee(s) as the insured; therefore, the company would pay the insurance premium, accumulate interest on the cash value of the policy or policies, and the company would receive the death benefit upon the death of the insured individual (regardless of the insureds’ affiliation with the company at the time of their death). Additionally, corporations were able to use COLI policy cash values as collateral for loans, which they could use as operating capital, and they would also claim the interest on the loan as a tax deduction. This practice was considered abusive by some and led to a lot of negative perceptions by critics, including media and other industry stakeholders.

Regulatory Changes
Recognizing the exploitative use of COLI by some corporations, Congress took a series of actions in the 1980s and 1990s to restrict and then eliminate a corporation’s ability to take tax deductions on COLI-related loans on policies covering employees or officers.[i]

State governments and state insurance commissions have also taken action against the exploitation of the favorable tax treatment of life insurance. This is significant because most insurance regulation occurs at the state level. One key change was the widespread adoption of an “insurable interest” mandate across state insurance commissions. As it relates to COLI, the State of New York defines a person (corporations can be considered persons) to have an insurable interest in another person if there is “a lawful and substantial economic interest in the continued life, health or bodily safety of the person insured, as distinguished from an interest which would arise only by, or would be enhanced in value by, the death, disablement or injury of the insured.”[ii]

Industry stakeholders and regulators have settled on New York’s definition of “insurable interest” and similar definitions and believe that corporations have an insurable interest in their executives and senior management personnel because the corporation relies on these individuals to oversee the daily operations of the business. Therefore, corporations can continue to purchase life insurance policies on employees but only if certain criteria are met. Specifically, the Company Owned Life Insurance ("COLI") Best Practices Act of 2005 mandates that companies can only take COLI policies out on the top 35% of employees as it relates to compensation and, amongst other things, the following:

• that employers provide written notice to employees whose lives the employer intends to insure,
• that the employee provides written consent to be insured, and
• that the insured employee is notified in writing that the applicable policyholder (typically the company or a trust appointed by the company) is the beneficiary set to receive the death benefit, and the amount of the death benefit.[iii]

Modern Application
While many of the policies established before the 1990s are still in-force, the modern application of COLI as an investment is much different than it used to be. Today, many companies use COLI to informally fund nonqualified deferred compensation plans or other executive retirement plans.

Three popular nonqualified plans are: Executive Deferred Compensation Plans (EDCP), Supplemental Executive Retirement Plans (SERP) and split dollar life insurance plans.

1. Executive Deferred Compensation Plans function in a manner similar to 401(k) plans in which employees select to defer a certain percentage or amount of their salary or bonus into a tax-deferred retirement account, thereby lowering their immediate tax burden and potentially accruing tax-deferred gains via the investments made in the EDCP account. To provide a tax-advantaged asset to informally fund an EDCP, a company may take out COLI policies on a number of employees who participate in the plan.
   
   Participation in an EDCP is limited to those designated by the sponsoring employer who are highly compensated and generally in management roles and who are interested in deferring compensation above 401(k) limits (the 2023 401(k) contribution limit is $22,500, or $30,000 for individuals 50 years or older). To accommodate for this benefit, employers are required to accrue a liability of the deferred compensation on their own balance sheets and settle the obligation from general assets of the company. This means that the compensation deferred into the EDCP becomes an unsecured obligation of the employer and the employee could lose their deferred compensation if the company becomes bankrupt. To facilitate the administration of an EDCP, employers typically contract a third-party administrator to provide account maintenance and recordkeeping services in a manner compliant with Internal Revenue Code regulations.
2. Supplemental executive retirement plans (SERP) are company paid deferred compensation benefits, typically with a service based vesting schedule that encourages employee retention. SERPs may be designed with a “defined benefit” formula, whereby the ultimate benefit is a pre-established amount, or a percentage of final compensation. Alternatively, SERPs may be designed with a “defined contribution” formula, whereby a specific amount or percentage of compensation is contributed by the company each year to an account of behalf of the employee, and the account is adjusted for earnings or losses based on the performance of an investment index.
3. Split dollar life insurance plans are plans that are structured between a key employee and the employer whereby the two parties come to an agreement that stipulates terms of how the premium costs, cash value and death benefits are shared or “split” between the parties. In addition, the agreement between the employee and employer usually includes provisions related to the duration of the agreement and the criteria for it to be unwound.

What does a company do when it decides it’s interested in establishing a nonqualified plan? We will address implementation and maintenance in upcoming blogs in the series – stay tuned!

[i] Congressional Research Service. Corporate-Owned Life Insurance (COLI): Insurance and Tax Issues. January 21, 2011. Available at: https://crsreports.congress.gov/product/pdf/RL/RL33414/7. Pages 3-4.

[ii] New York Consolidated Laws, Insurance Law - ISC § 3205. Available at: https://codes.findlaw.com/ny/insurance-law/isc-sect-3205.html

[iii] H.R. 2251. Available at: https://www.congress.gov/bill/109th-congress/house-bill/2251/text?s=1&r=45